Deductible expenses (including depreciation)
Owning a property has much in common with owning your own small business. Every year, you account for your income and expenses on a tax return. One expense that you get to deduct for rental real estate on your tax return — depreciation — doesn’t actually involve spending or outlaying money.Depreciation is an allowable tax deduction for buildings, because structures wear out over time. Under current tax laws, residential real estate is depreciated over 27 1/2 years (commercial buildings are less favored in the tax code and can be depreciated over 39 years). Residential real estate is depreciated over shorter time periods because it has traditionally been a favored investment in our nation’s tax laws.
Tax-free rollovers of rental property profits
When you sell a stock, mutual fund, or exchange-traded investment that you hold outside a retirement account, you must pay tax on your profits. By contrast, you can avoid paying tax on your profit when you sell a rental property if you roll over your gain into another like-kind investment real estate property.The rules for properly making one of these 1031 exchanges are complex and involve third parties. Make sure you find an attorney and/or tax advisor who is an expert at these transactions to ensure that you meet the technical and strict timing requirements so everything goes smoothly (and legally).
If you don’t roll over your gain, you may owe significant taxes because of how the IRS defines your gain. For example, if you buy a property for $200,000 and sell it for $550,000, you not only owe tax on the gain from the increased property value, but you also owe tax on an additional amount, the property’s depreciation you used during your ownership.The amount of depreciation that you deduct on your tax returns reduces the original $200,000 purchase price, making the taxable difference that much larger. For example, if you deducted $125,000 for depreciation over the years that you owned the property, you owe tax on the difference between the sale price of $550,000 and $75,000 ($200,000 purchase price – $125,000 depreciation).